Bonds play a big part in many investors' ISAs and pensions. However, experts fear fixed interest stocks are treading on thin ice.

Right now there is a huge debate as to whether there is a dangerous bubble in bonds, which are the loans or IOUs issued by governments and companies when they want to borrow money.

Traditionally, investors have liked bonds because most of them pay a fixed rate of interest. As an asset class in their own right, bonds sit well alongside shares in many people's ISAs or pension plans. Experts say adding bonds to an investment portfolio helps make the returns less volatile.

However, many bonds have become expensive. This video explains what you need to know to understand the crucial debate around fixed interest stocks.

Can't watch a video right now? You can read the transcript instead. See below.

The Lolly survival guide to investing in bonds:

We all like talking about the weather don’t we?

In investment right now the big debate is to what extent should investors be wearing the financial equivalent of snow boots and puffa jackets.

I’m talking about bonds!

Bonds are one of the big asset classes we keep coming back to in this series.

They’re tradeable loans issued by governments and companies.

Traditionally they’ve been seen as defensive, more stable than racy shares.

A good thing to hold alongside shares in your ISA or pension.

The trouble is the outlook for bonds is very cloudy at the moment. There could be danger ahead.

Bonds’ reputation for safety is based on the fact that most bonds pay a fixed rate of interest.

This is unlike shares which might pay you a dividend – or might not.

As a result you kind of know where you are with bonds. Don’t you?

Wrong! Many experts are alarmed that bond prices are dangerously high. They fear the ground on which bond investors walk is icy, that the unwary may take a nasty tumble.

To understand why experts are concerned you have to know what makes bond prices move.

Two main factors affect bonds: the first being interest rates and connected to them the level of inflation.

At the moment interest rates are stuck at an all-time low. At some point they’ll have to rise.

But rising interest rates are bad for bonds because it makes the fixed rate of interest they pay less attractive. Fewer investors buy them so their price drops.

Bonds also hate inflation as it gradually erodes the value of their fixed returns.

The threat of rising inflation hits bond prices because it means central banks will raise interest rates to stop the economy overheating.

Experts worry we’re set for an inflation shock in the future. All the hundreds of billions of pounds and dollars that the Bank of England and the US Federal Reserve have created to avoid a depression could be building up inflation in the global economy.

That would be bad news for bonds.

The second big factor affecting bond prices is the credit rating of the country or company behind the bond.

If the bond issuer is financially strong and has a good credit rating it can borrow cheaply and pay a lower rate of interest.
However, if it’s financially weak and has a lower rating it will pay a higher rate of interest on its bonds.

Historically, government bonds from mature, developed economies such as the UK, US or Germany were seen as rock solid. With top AAA credit ratings they could pay the smallest amount of interest.

Below them were corporate bonds from big businesses. Although investment grade they were not quite so safe and would pay a higher rate of interest – or spread – over what the government bonds paid.

Below them would be financially weak or struggling companies. Deemed non-investment grade they would have to pay an even higher interest rate. They are known as high yield or ‘junk’ bonds.

Last of all were the government bonds from emerging markets which also paid a high interest rate.

The financial crisis has changed all this.

The big budget deficits of the UK and the US mean their government bonds are not as attractive as they used to be. The US lost its AAA rating two years ago and the UK could lose its top credit rating this year.

Nowadays most investors prefer corporate bonds, high yield bonds and emerging market bonds. This is because many big businesses and many of the countries we used to dismiss as ‘emerging’ are in financially better shape than the debt-laden western economies.

So is there a bubble in bonds? Yes, there certainly is in UK government bonds or gilts and US government bonds, known as treasuries.

This is because the Bank of England and US Fed used the QE money to buy their government bonds. Gilt and treasury prices have soared taking the rest of the bonds market, which are priced off these government bonds, with them.

The situation is not quite so serious in corporate, high yield or emerging market bonds but even here prices look stretched. A slump in gilts and treasuries could hit these other bonds too.

The key to what happens is the state of the UK, US and global economies and how much more QE the Bank of England and Fed will do?

If the UK and US continue to dip in and out of recession then bonds will continue to look attractive to some investors, even though they are expensive and their rates of return are poor.

But if there is any sign of a sustained recovery and central banks ending their programme of printing money, bond markets will go into reverse.

There is no question but that the exercise of QE as directed by the BoE under Mervyn King has heavily skewed the market price of gilts.

The policy of QE as exercised by the BoE has, at the best, proved almost entirely ineffective in restoring the economy, and at worst, has introduced a level of instability into the gilts market from which it is impossible to envisage an orderly exit strategy.

However, the argument on the inflationary effect of this form of QE is not valid. One government department repurchasing debt instruments issued by another does not directly cause inflation. One form of HMG indebtedness is merely replaced with another i.e.

cash = zero coupon debt redeemable on demand;

gilts = coupon bearing debt generally with redemption date.

In the esoteric language of the money world 'narrow' money is increased but 'broad' money does not change, and it is in broad money that the effects of inflation are felt.

In any case most new money derives not from HMG's printing press, but from the leverage applied through the commercial banks application of fractional reserve banking. The present pressure on the banks to increase capital and liquidity ratios has a deflationary effect on the economy.

What is inflationary is that the government continues to outspend its income and the Treasury continues to borrow more from the market via issuance of new gilt stock to 'balance' its budgets.

The Chancellor's austerity programme has been directed indiscriminately at cutting both consumption (essential if we are to live within our means) and at the maintenance or formation of capital infrastructure (insane). Carefully selected infrastructure investment is self justifying, the value of the capital assets providing a justification in the capital account for the expenditure incurred. It creates a cascade of activities on a broad path and so benefits the wider economy.

Other dimensions of UK government policy are also unhelpful, whether threatening to violate the diplomatic immunity of the embassies of small countries, or in the latest stunt, challenging our treaty relationships with our closest trading partners (this appears to have accelerated the pound into near free fall. Since July the pound has lost 8% of its value versus the Euro!).

None of these actions reassure the foreign investors upon whom we rely to continue funding the UK's gaping trade deficit, and it is ultimately those who are lending us the money who are going to call time on the low interest rates and on our debt funded economy.

The present very low interest rates sustain the high bond valuations. The rates also sustain high valuations for equities. Gilts are in a special category because there is a finite supply in issue for which the BoE has competed in the market place with the pension funds that are obliged to hold them. The result of the actions of the BoE has been to transform a conventionally 'safe' form of investment in to one of high risk (well done MK?). Any collapse in the pricing of long term and perpetual gilts will devastate pension fund reserves.

So are bond valuations at risk? Yes, indubitably so. But are equities much safer, or is cash or gold best? The problem relates also to questions about timing, and about investment objectives.

Is the objective to secure a particular real or nominal level of income or to preserve the real or nominal value of capital? [real = inflation adjusted]

Generating a relatively secure nominal income can be achieved without too much difficulty.

Generating real returns and protection of value in real terms is much more difficult. Totally secure protection of income or capital in real terms is not possible. Not even index linked bonds are fully immune to the effects of inflation. The annually adjusted reference 'baskets' of goods now even include ephemera. The effect is that the indices do not provide a fully reliable constant point of reference and often underestimate the true effects of inflation as (for example) it might apply to a retired person.

In today's market most investment asset classes are looking very expensive. Historically rallies around Xmas and the New Year are the worst time possible (other than Easter perhaps) at which to invest money. In the UK these are always the times when most people want to make investments. This is due to the ending of the calender year (which corresponds to the company reporting year for many companies) and the end of the fiscal year. In nominal terms a lot of portfolio values are looking very good now, and mark a welcome improvement from the lower values recorded last summer. But how well are they really doing if expressed in terms of Euro purchasing power factoring for the 8% lost value of the £ over the last 6 months?

In summary. Cash ... values are being eroded by inflation.

Bonds present high valuations depend upon continuance of low interest rates. No real sign that rates are going to change any-time soon because political consequence will be too painful for parties in office before election. In long term interest rates must go up, but how far to the long term?

Fixed interest gilts are paying a coupon too low to match inflation and carry the risk of price falls if not held to redemption. Value sustained for as long as the BoE remains in the market.

Index linked gilts, not perfect, and very expensive for the expected returns, but not a bad hedge for protecting real values.

High risk (or junk) bonds. High percent coupon payout may beat inflation if reinvested. Can also provide a good source of cash if/when equity values get beaten down. Usually limited liquidity makes these expensive to buy and sell (wide trading margins) and are not generally suitable for short term investment. High risk? You could lose the lot! Make sure that you see the precise terms before buying. But may be a worthwhile ingredient in a diversified portfolio.

Equities. Good businesses that supply essential goods or services will be needed tomorrow as they are today. If they are to succeed in tomorrow's world, then they will reflect the values of that world. So conceptually they are inflation proofed investments. However, there are few if any companies, blue chip or otherwise, which considered individually can be seen as safe roads to the future. British Steel, Marconi, ICI, BICC etc.etc. all companies involved in products still needed today, but all vanished. The other consideration lies in the re-structuring of economies. There is no certainty that tomorrows market's will attribute the same real valuations to equities tomorrow as they do today. With national and global debt increasingly critical there is a real possibility of a large correction to the downside.

It looks hopeless, what can I do? Make no investment where you cannot tolerate the foreseeable downside. Otherwise create a pool of diversified investments avoiding excessive focus on any one company, sector, or type of investment. ETFs and investment trusts can provide relatively low cost access to diversified pools of equities, but don't trust any one fund manager too much, or you will lose the advantage of diversification (and it may hurt). No one out there knows it all!